July 17, 2019

A Tale of Two Dividend Cuts

Income Strategy 2Q 2019 Letter

The Income Strategy returned 0.56% (net of fees) in the second calendar quarter of 2019, while the Merrill Lynch High Yield Index returned 2.55%. Despite underperforming our benchmark in the second quarter, we ended the quarter still ahead of the benchmark so far this calendar year. We have also recaptured almost all of the second quarter’s relative underperformance in just the first two trading weeks of the third quarter, which shows how different we are from income strategies that prioritize low volatility over total-return potential.

To refresh readers’ memories on our process, Income Strategy’s primary goal is to generate a high level of income while preserving the potential for capital appreciation. We try to do this by owning securities that are not only high-yielding but also undervalued. If we are correct that the price does not adequately reflect the security’s potential future cash flows, we hope to also capture capital appreciation on top of our yield. The high-yielding security landscape is littered with landmines, and we will make our fair share of mistakes, but we hope to make more money on the securities where we are right than we lose on those where we are wrong. With that said, we will examine the thought process behind one recent mistake as well as a position we added to meaningfully, in an effort to help shareholders better understand how we think.

Our biggest mistake this quarter is one that investors will not be aware of unless they read this update because we cut bait so quickly that we didn’t even own the stock for a full quarter. In May, we initiated a position in the secularly-challenged GameStop (GME), which faces a double-whammy – 1) brick-and-mortar retail is moving online, and 2) video games are increasingly distributed digitally. We were well aware of the issues, but our analysis suggested the valuation was nearing a point where astute capital allocation could generate substantial shareholder value. The previous management team announced a strategic review last year, causing the stock to pop from $13 to $16 in short order, with sell-side analysts estimating a private take-out value somewhere between 2x and 3x our ultimate entry price. When we bought the stock this May, its total market capitalization was approaching the value of the company’s last-reported net cash level, or the value of the total dollars sitting in the bank assuming the company had already paid back all of its outstanding debt (excluding lease commitments). In other words, the market was giving the company very little credit for any future free cash flow at all; though free cash flow is clearly shrinking, we thought it was highly probable that some free cash would materialize. We anticipated the upcoming seasonal cash burn, but we did not anticipate the dividend elimination combined with the new management’s team’s commitment to “reinvigorate growth” without any tangible plan.

Generally speaking, equity owners do not like it when management eliminates a dividend unnecessarily with no credible better use for the capital. Conversely, bondholders typically applaud when management eliminates a dividend because less cash to shareholders means more cash and financial flexibility to pay back bondholders. A funny thing happened though in conjunction with GameStop’s dividend elimination – both the equity and the bonds fell in value. Some of the decline was clearly due to weakness in the business, but we think the magnitude of the decline in both the bonds and the equity could be due to the market sniffing out poor process, namely a major capital allocation change without a clearly communicated plan. Poor process at the top tends to be insidious and does not bode well for any business, especially a secularly challenged one. Interestingly enough, management has continued to allocate capital in ways that do not engender confidence after our exit, and the market has continued to thrash the stock. Three days after the share price tanked more than 35% on the dividend elimination, management announced that they were going to repurchase 12M shares via a tender offer. A large share repurchase in the case of a significantly undervalued stock is a great use of capital, assuming management has some sense of what their shares are worth. How, exactly, this management team knows what GameStop shares are worth prior to communicating a credible plan for the retained capital is a mystery, which may be why the shares trade lower as of this writing than they did prior to the share repurchase.

We try to avoid management teams demonstrating subpar capital allocation processes while adding to positions where management demonstrates a thoughtful, value-additive process. In the case of many secularly challenged businesses, management has no good investment options for the profits and therefore should continue to distribute the bulk of free cash flow as a dividend. However, for leveraged secular shrinkers, the optimal use for the cash flows is often a reduction in debt. Otherwise, the equity value is likely to decline at an increasing rate as the shrinking cash flows being paid out to shareholders have the effective result of boosting leverage as profits fall faster than debt outstanding.

In contrast, while the new management team at CenturyLink (CTL) previously committed to the prior dividend, we think the dividend reduction was prudent for the aforementioned reason, even though there may be some short-term credibility concerns. Our work on the new capital allocation framework gives us comfort that the company can indeed deleverage, which should boost prices at multiple levels in the capital structure, which is why we added significantly to the long-dated bonds. If management can hit their deleveraging targets on schedule, we believe there is a significant probability that the 13% discount to par at our average cost will become a double-digit premium to par, if the debt prices of less-leveraged telecom operators are a reliable indication. We think this is likely to happen as bondholders accrue a nice 7.6% rate of interest, which, if we are right, would generate a very nice risk-adjusted return.

Spilling a lot of ink on a mistake that would otherwise not rise to our investors’ attention is probably not typical content for most quarterly letters, but we are not running a typical strategy, and we think it is important that investors understand our process given the unconstrained and atypical nature of what we do. As always, we appreciate your support and remain the largest investors of the Strategy, and we welcome any questions or comments.

Bill Miller IV, CFA

Strategy Highlights by Tyler Grason

Top Contributors

Alternative Asset Managers Carlyle Group (CG) and Apollo Global Management (APO) were both top contributors, rising 24.83% and 23.15%, respectively, over the quarter and in conjunction with the broad equity market.

Carlyle reported distributable earnings of $0.25, falling short of street estimates of $0.36 but included a previously accrued $20M, or $0.06 drag, from a clawback in a legacy energy fund. Fee-related earnings beat, however, coming in at $103M in the quarter versus consensus of $100M and remains on track to hit $400M for the full year, implying 15% growth over 2018. Assets under management (AUM) and fee-paying AUM increased 10% and 27%, respectively, year-over-year, and management noted they have completed 97% of their $100B fundraising target with expectations to exceed $100B by 10%. After quarter-end, management confirmed the company will indeed become a C-corp.

Apollo Global reported distributable earnings of $0.50, missing consensus estimates of $0.55 due to lower-than-expected advisory and transaction fees. Fee-related earnings and gross realized performance fees were strong at $210M and $64M, respectively. Fee-earning AUM of $228.3B was +6% sequentially and capital raising remained robust with $17B of gross AUM inflows. Permanent capital reached $148B, or 49% of total AUM. Management announced their plans to convert to a C-corp effective 3Q19 and expects no change to the dividend policy.

Just Energy Group (JE CN) advanced 27.03% over the period. The company reported fiscal Q4 EBITDA of C$69M, falling short of consensus of C$75M, driven by a lower-than-expected gross margin of C$198M. Gross margins per residential customer ticked higher to C$386 (+11% sequentially) as the company continues to execute on its strategy of adding higher-margin customers. Management initiated fiscal 2020 EBITDA guidance of C$220M-C$240M (+13% year-over-year at the midpoint) and free cash flow guidance of C$90M-C$100M with potential upside from working capital improvements. The company maintained its $0.125/share dividend (9.1% annualized yield). Further, the Board of Directors announced they’re undertaking a formal review process to evaluate strategic alternatives following expressions of interest from a number of parties.

Top Detractors

GameStop (GME) was the top detractor over the quarter falling -46.16%. The company reported revenues of $1.55B, missing consensus of $1.64B driven by declines in new the hardware and pre-owned segments. EPS of $0.07 beat analyst estimates of a loss of $(0.03), but same-store sales of -10.3% were well below consensus of -6.9%. The company elected to eliminate the dividend and intends to re-allocate the capital to reduce debt and provide flexibility. Management reiterated prior topline guidance of -5% to -10% for both comp store sales and total revenue and maintained their target of $100M in profit improvement by 2020.

Quad Graphics (QUAD) fell -31.53% during the period despite posting solid Q1 results where revenues of $1.0B topped estimates of $980M and EBITDA of $70M was in-line. The company maintained their $0.30/share dividend (15.8% annualized yield). Share price weakness stemmed from the Department of Justice filing an antitrust lawsuit seeking to block Quad’s proposed acquisition of LSC Communications (LKSD), alleging the deal would eliminate their principal competitor.

Greenhill & Co (GHL) fell -36.62% over the quarter after reporting a wider than expected Q1 loss of $(0.64) versus estimates of $(0.11), driven by weaker-than-estimated advisory fees of $51M. The company repurchased $24M of shares over the period, leaving $75M on its authorization after refinancing and upsizing its term loan facility to $375M. Management remains constructive on the M&A market for the balance of the year, noting they have seen a rebound in recent deal activity, driven by equity markets returning to all-time highs and financing markets reopening.

Past performance is no guarantee of future results. For important additional information on Income Strategy performance, please click on the Income Strategy GIPS Composite Disclosure. This additional information applies to such performance for all time periods.

Contact Miller Value Partners to obtain information on how Top Contributors and Top Detractors were determined and/or to obtain a list showing every holding’s contribution to Strategy performance.

Investment Risks: All investments are subject to risk, including possible loss of principal.

The views expressed in this report reflect those of Miller Value Partners portfolio manager(s) as of the date of the report. Any views are subject to change at any time based on market or other conditions, and Miller Value Partners disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results.